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Tuesday, April 17, 2012

Adjusting Portfolios to Account for Investor Behaviour

We now understand well that investors consistently make certain types of behavioural mistakes, such as selling stocks after the market drops, buying back in when stocks are soaring, and chasing last year’s hot mutual fund. How best to adjust portfolios to deal with these cognitive errors is a subject for debate.

One approach is to take the way an investor feels about gains and losses and construct an asset allocation that maximizes the investor’s perceived net gain. This is the approach taken by Morningstar with their star ratings that bake in an assumed average level of risk aversion. However, this can lead to extremely conservative portfolios, which is not in the best interests of most investors.

The real answer is to evaluate potential asset allocations based on two criteria. The first is how beneficial the allocation would be for the investor (as opposed to how comfortable the investor would be). The second is how likely the investor is to stick with the allocation through thick and thin and how much his returns will suffer when he deviates from the plan.

Let’s consider an example. Suppose that a young nervous investor has little stomach for stock volatility and may not be able to handle more than a 20% stock allocation without bailing at the next big drop in stock prices. A careful analysis of this investor’s financial life might indicate that his stock allocation should be 75% if only he could handle it. Settling for 20% would be a big penalty.

But, suppose that this investor could be distracted by dividends. By choosing ETFs that specialize in dividend-paying stocks and getting the investor to focus on the fairly steady dividend stream from the ETFs, he might be able to stick with a larger allocation to stocks.

The penalty for lack of diversification that comes with specializing in dividend-paying stocks is likely to be much lower than the expected penalty of only allocating 20% of a portfolio to stocks. Both approaches may make the investor equally comfortable, but the dividend approach has much better expected returns and matches the investor’s needs better. Even better would be broad stock index ETFs, but this just isn’t possible for this nervous investor.

The basic idea is to match investors’ needs as best as possible taking into account their behaviours. This is very different from just trying to make investors comfortable.